CFA level 1 study notebook5 2015

describe contingency provisions affecting the timing and/ornatureof cash flows of fixed-incomesecuritiesand identify whether such provisions benefit theborrowerorthelender,page19 The top

BOOK 5 - FIXED INCOME, DERIVATIVES,

SCHWESERNOTES™ 2015CFALEVEL I BOOK5: FIXEDINCOME,

DERIVATIVES, ANDALTERNATIVE INVESTMENTS

©2014 Kaplan,Inc.All rights reserved

Published in 2014byKaplan,Inc

Printedinthe UnitedStatesofAmerica

ISBN:978-1-4754-2760-8/1-4754-2760-3

PPN:3200-5526

If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was

distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation

of global copyright laws Your assistance in pursuing potential violators of this law is greatly appreciated.

Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy

or quality of the products or services offered by Kaplan Schweser.CFA®and Chartered Financial

Analyst® are trademarks owned by CFA Institute.”

Certain materials contained within this text are the copyrighted property of CFA Institute The

following is the copyright disclosure for these materials: “Copyright, 2014, CFA Institute Reproduced

and republished from 2015 Learning Outcome Statements, Level I, II, and III questions fromCFA®

Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institutes Global

Investment Performance Standards with permission from CFA Institute All Rights Reserved.”

These materials may not be copied without written permission from the author The unauthorized

duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics.

Your assistance in pursuing potential violators of this law is greatly appreciated.

Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth

by CFA Institute in their 2015 CFA Level I Study Guide The information contained in these Notes

covers topics contained in the readings referenced by CFA Institute and is believed to be accurate.

However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam

success The authors of the referenced readings have not endorsed or sponsored these Notes.

READING ASSIGNMENTS AND

Thefollowingmaterialisa reviewofthe FixedIncome, Derivatives,and Alternative

Investmentsprinciples designedtoaddress the learningoutcome statements setforthby

51.Fixed-Income Securities:DefiningElements

52 Fixed-Income Markets:Issuance,Trading, and Funding

53 IntroductiontoFixed-Income Valuation

54.IntroductiontoAsset-BackedSecurities

page 9page27

page41page 79

STUDY SESSION 16

Reading Assignments

Equity and FixedIncome,CFA Program LevelI2015Curriculum,Volume5(CFA

Institute, 2014)

55.Understanding Fixed-Income Risk andReturn

56.Fundamentalsof Credit Analysis

page 103

page133

STUDY SESSION 17

Reading Assignments

Derivativesand AlternativeInvestments,CFAProgram LevelI2015Curriculum,

Volume 6(CFA Institute,2014)

57.DerivativeMarkets andInstruments

58.BasicsofDerivativePricing and Valuation

59 Risk Management Applications of Option Strategies

DerivativesandAlternativeInvestments,CFA Program Level I 2015Curriculum,

Volume 6(CFA Institute,2014)

LEARNING OUTCOME STATEMENTS (LOS)

The CFAInstituteLearning Outcome Statementsarelisted below Thesearerepeatedineachtopicreview; however,theorder may have beenchangedinordertoget abetterfitwith the

flow ofthereview

STUDY SESSION 15

The topicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading:

51 Fixed-IncomeSecurities:Defining ElementsThecandidate should be ableto:

a. describe the basicfeatures ofafixed-incomesecurity,(page9)

b describe functionsofabondindenture,(page11)

c. compareaffirmative and negativecovenantsand identify examples of each

(page11)

d describe how legal,regulatory,andtaxconsiderationsaffect theissuanceandtrading of fixed-incomesecurities,(page12)

e. describe how cash flowsof fixed-incomesecuritiesarestructured,(page15)

f describe contingency provisions affecting the timing and/ornatureof cash flows

of fixed-incomesecuritiesand identify whether such provisions benefit theborrowerorthelender,(page19)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

52 Fixed-Income Markets:Issuance,Trading, and FundingThe candidate should be ableto:

a. describe classifications of global fixed-incomemarkets,(page27)

b describe theuseof interbank offeredrates asreferenceratesinfloating-ratedebt

(page28)

c. describe mechanisms availablefor issuing bondsinprimarymarkets,(page29)

d describe secondary markets forbonds,(page30)

e. describesecuritiesissued by sovereigngovernments,non-sovereigngovernments, governmentagencies, and supranationalentities,(page30)

f describetypesof debt issued by corporations, (page32)

g describe short-term funding alternatives availableto banks,(page34)

h describerepurchaseagreements(repos)and their importanceto investorswho

borrow shortterm,(page34)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

53 IntroductiontoFixed-Income ValuationThe candidate should be ableto:

a. calculateabond’sprice givenamarket discountrate,(page41)

b identify the relationshipsamongabond’s price,couponrate,maturity, andmarket discountrate(yield-to-maturity) (page43)

c. definespot ratesand calculate the price ofabond usingspot rates,(page45)

d describe and calculate the flat price, accruedinterest,and the full price ofa

bond,(page46)

e. describematrixpricing,(page48)

f calculate and interpret yieldmeasuresfor fixed-ratebonds,floating-ratenotes,

andmoneymarketinstruments,(page50)

g define and compare thespot curve,yieldcurveoncouponbonds,parcurve,and

forwardcurve, (page57)

h define forwardratesand calculatespot ratesfrom forwardrates,forwardrates

fromspot rates,and thepriceofabond using forwardrates,(page59)

i compare,calculate,and interpret yield spreadmeasures,(page63)

The topical coverage corresponds with thefollowingCFA Instituteassigned reading:

54 IntroductiontoAsset-Backed Securities

The candidate should be ableto:

a. explainbenefitsofsecuritizationforeconomiesand financialmarkets,(page79)

b describe thesecuritizationprocess, including the partiestothe process, the roles

they play, and the legalstructuresinvolved,(page80)

c. describetypesand characteristics of residentialmortgageloans thataretypically

securitized,(page82)

d describetypesand characteristicsof residential mortgage-backedsecurities,and

explain the cash flows and credit risk for eachtype,(page84)

e. explain themotivationfor creating securitizedstructureswith multiple tranches

(e.g., collateralizedmortgageobligations), and the characteristics and risks ofsecuritizedstructures,(page87)

f describe the characteristics andrisksof commercialmortgage-backedsecurities

(page92)

g describetypesand characteristicsofnon-mortgageasset-backedsecurities,

includingthe cash flows and credit riskof eachtype,(page95)

h describe collateralized debt obligations, including their cash flows and credit

risk,(page96)

STUDY SESSION 16

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

55.Understanding Fixed-IncomeRiskandReturn

The candidate should be ableto:

a. calculate and interpret thesourcesofreturnfrom investinginafixed-rate bond

(page103)

b define, calculate,and interpret Macaulay,modified,and effective durations

(page109)

c. explain why effective durationisthemostappropriatemeasureofinterestrate

riskfor bonds with embedded options, (page113)

d define keyrateduration and describe the keyuseof keyratedurationsin

measuring the sensitivity of bondstochangesinthe shape of the benchmarkyieldcurve,(page114)

e. explain howabond’smaturity,coupon, embedded options, and yield level affect

its interestraterisk,(page114)

f calculate the duration ofaportfolio and explain the limitations of portfolio

duration,(page115)

g calculate and interpret themoneyduration ofabond and price value ofabasis

point(PVBP).(page116)

h calculate and interpretapproximate convexityand distinguish betweenapproximate and effectiveconvexity,(page117)

i estimatethepercentageprice change ofabondforaspecified changeinyield,given the bond’sapproximate duration and convexity, (page120)

j describe how theterm structureof yield volatility affects theinterestrateriskof

a bond,(page121)

k describe the relationships amongabond’s holding periodreturn,its duration,

and theinvestmenthorizon,(page121)

1 explain how changesincredit spread and liquidity affect yield-to-maturityofa

bond and how duration andconvexitycanbe usedtoestimatethe price effect ofthe changes, (page123)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

56 Fundamentalsof Credit AnalysisThe candidate should be ableto:

a. describe credit risk and credit-related risksaffectingcorporate bonds,(page133)

b describe seniority rankings ofcorporatedebt andexplain the potential violation

of the priority of claimsinabankruptcy proceeding, (page134)

c. distinguish betweencorporateissuercredit ratings andissuecredit ratings anddescribe the ratingagencypractice of “notching”, (page135)

d explain risksinrelyingonratings from credit rating agencies,(page136)

e. explain thecomponentsof traditional credit analysis, (page137)

f calculate and interpret financialratiosusedincredit analysis, (page139)

g evaluate the credit quality ofa corporatebondissuerandabondof thatissuer,

givenkeyfinancialratiosof theissuerand theindustry, (page143)

h describe factors that influence the level and volatility of yield spreads, (page144)

i calculate thereturnimpact ofspread changes, (page145)

j explain special considerations whenevaluatingthe creditofhighyield,sovereign, andmunicipal debtissuersandissues,(page147)

STUDY SESSION 17

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

57 DerivativeMarkets andInstrumentsThe candidateshouldbe ableto:

a. defineaderivative,anddistinguishbetweenexchange-tradedand

over-the-counter derivatives,(page165)

b contrastforwardcommitmentswith contingentclaims,(page165)

c. define forwardcontracts,futurescontracts,options(callsand puts), swaps, andcreditderivatives,andcomparetheir basiccharacteristics,(page166)

d describepurposes of,andcontroversiesrelatedto,derivativemarkets,(page171)

e. explain arbitrage and the roleitplaysindeterminingprices and promotingmarket efficiency, (page171)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

58 BasicsofDerivativePricingand Valuation

Thecandidate should be ableto:

a. explainhow theconceptsofarbitrage, replication,and riskneutralityareusedin

pricingderivatives,(page176)

b distinguish between value andpriceof forward and futurescontracts,(page178)

c. explain how the value and price ofaforwardcontractaredeterminedat

expiration, during the life of thecontract,andat initiation,(page179)

d describemonetaryandnonmonetarybenefits andcostsassociated withholding

the underlyingasset,andexplain how they affect the value and price ofa

forwardcontract,(page180)

e. defineaforwardrate agreementand describeitsuses.

f explain why forward and futures prices dilfer (page182)

g explain howswapcontracts aresimilartobut differentfromaseriesof forward

contracts,(page183)

h distinguish between the value and price ofswaps,(page183)

i. explainhow the valueofaEuropean option is determinedatexpiration

(page184)

j explain theexercise value, time value,andmoneynessofanoption, (page184)

k identify the factors that determine the value ofanoption, andexplain how each

factor affects the value ofanoption, (page186)

1 explain put-call parity for European options, (page187)

m. explain put-call-forwardparity forEuropeanoptions,(page189)

n explain how the value ofanoptionisdetermined usingaone-period binomial

model,(page190)

o. explain under whichcircumstancesthe values of European andAmerican

optionsdiffer,(page193)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

59 RiskManagementApplicationsof Option Strategies

The candidate should be ableto:

a. determine the valueatexpiration, theprofit,maximumprofit,maximum loss,

breakevenunderlyingpriceatexpiration, and payoffgraph of the strategies

of buying and selling calls andputsand determine the potentialoutcomesfor

investorsusing these strategies,(page203)

b determinethe valueatexpiration,profit,maximumprofit,maximumloss,

breakeven underlying priceatexpiration, and payoff graph ofacoveredcallstrategyandaprotectiveput strategy,and explain the riskmanagement

application of eachstrategy,(page207)

(page180)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

60.IntroductiontoAlternativeInvestments

The candidate should be ableto:

a. comparealternativeinvestmentswith traditionalinvestments,(page213)

b describe categories of alternativeinvestments,(page213)

c. describe potential benefits of alternativeinvestments inthecontextof portfolio

management,(page214)

d describe hedgefunds,private equity, realestate,commodities,and other

alternativeinvestments,including,asapplicable, strategies, sub-categories,potential benefits andrisks,feestructures,anddue diligence.(page215)

describeissues invaluing, and calculatingreturns on,hedgefunds,privateequity, realestate,andcommodities,(page215)

describe, calculate,and interpretmanagementandincentivefees and net-of-feesreturns tohedgefunds,(page227)

describe riskmanagementof alternativeinvestments,(page229)

e.

f

g-outcome statements set forth by CFA Institute This topic is also covered in:

ELEMENTS

StudySession 15

EXAM FOCUS

Here yourfocus shouldbeonlearning the basic characteristicsofdebtsecuritiesandas

much of the bondterminologyasyou canremember Keyitemsarethecouponstructure

of bonds and options embeddedinbonds: call options,putoptions, andconversion (to

common stock)options

BOND PRICES,YIELDS,AND RATINGS

Therearetwoimportant points about fixed-incomesecuritiesthatwewill develop

further alonginthe FixedIncomestudysessionsbutmaybe helpfulasyouread this

topicreview

• Themostcommontypeof fixed-income securityisabondthat promisestomake

aseriesofinterestpaymentsinfixedamountsandtorepaythe principalamount

atmaturity.When marketinterestrates(i.e.,yieldson bonds)increase,the value

of such bonds decreases because thepresentvalueofabond’s promised cash flows

decreases whenahigher discountrateisused

• Bondsarerated basedontheir relative probability of default(failuretomake

promised payments) Becauseinvestorsprefer bonds with lower probability of

default,bonds with lower creditqualitymustofferinvestorshigher yieldsto

compensatefor thegreaterprobability of default Other thingsequal,adecreasein

abond’s rating(anincreased probability ofdefault)will decrease the price of the

bond,thus increasingitsyield

LOS 51.a:Describe the basicfeatures ofafixed-incomesecurity

CFA®Program Curriculum,Volume5,page296

Thefeatures ofafixed-income security include specification of:

• Theissuerof the bond

• Thematuritydate of the bond

• Theparvalue (principal valuetobe repaid)

• Couponrateandfrequency

• Currencyinwhichpaymentswill be made

Issuersof BondsThere areseveraltypesofentitiesthatissuebonds whenthey borrowmoney,including:

• Corporations Oftencorporatebondsaredividedintothose issued by financial

companies and those issuedbynonfinancial companies

• Sovereign nationalgovernments.AprimeexampleisU.S.Treasurybonds,but

many countries issuesovereign bonds

• Nonsovereigngovernments.Issued bygovernmententitiesthatarenotnational

governments,suchasthestateof Californiaorthe city of Toronto

• Quasi-governmententities.Notadirect obligation ofacountry’sgovernmentor

central bank.Anexampleisthe Federal National MortgageAssociation(Fannie Mae).

• Supranationalentities.Issued by organizations thatoperateglobally suchastheWorldBank,theEuropean InvestmentBank,and theInternational Monetary Fund

(IMF)

BondMaturityThematuritydateofabondisthe dateonwhich the principalistobe repaid Oncea

bond has beenissued,thetimeremaining until maturityisreferredto astheterm tomaturityor tenorofabond

When bondsareissued,theirterms tomaturityrangefromonedayto30yearsor more.

Both Disney and Coca-Cola have issued bonds with originalmaturitiesof

100 years.Bonds thathavenomaturity datearecalled perpetual bonds They makeperiodicinterestpaymentsbut donotpromisetorepay theprincipalamount.

Bonds with originalmaturitiesofoneyear orlessarereferredto asmoney marketsecurities.Bonds with originalmaturitiesofmorethanoneyear arereferredto ascapitalmarketsecurities

ParValue

Theparvalueofabondisthe principalamountthat will be repaidatmaturity Thepar

valueisalso referredto asthefacevalue, maturityvalue,redemptionvalue, orprincipalvalueofabond Bondscanhaveaparvalueofanyamount,and theirprices arequoted

as a percentageofpar Abond withaparvalueof$1,000quotedat98isselling for

$980

Abond thatisselling formorethanits parvalueissaidtobe tradingat apremiumto

par;abond thatissellingatless thanits parvalueissaidtobe tradingat adiscountto

par;andabond thatissellingfor exacdyits parvalueissaidtobe tradingatpar

witha5%couponwouldpay2.5%of $1,000,or $25,everysixmonths.Abond witha

fixedcouponrateiscalledaplain vanilla bondor aconventional bond

Somebondspayno interestpriortomaturityandarecalledzero-couponbondsorpure

discount bonds.Purediscountreferstothefact that these bondsaresoldat adiscount

totheirparvalue and theinterest isall paidatmaturitywhen bondholdersreceivethe

par value A 10-year,$1,000,zero-couponbond yielding7%would sellatabout$500

initiallyand pay$1,000 atmaturity We discussvariousothercouponstructureslater in

this topicreview.

Currencies

Bondsareissuedin many currencies Sometimesborrowersfromcountrieswith

volatile currencies issuebonds denominatedineurosorU.S.dollarstomake them

moreattractiveto awiderangeinvestors.Adual-currency bondmakes couponinterest

paymentsinonecurrencyand the principalrepayment atmaturity in another currency

A currencyoption bond gives bondholdersachoiceof which oftwo currenciesthey

would liketo receivetheirpaymentsin

LOS51.b:Describe functionsofabond indenture

LOS51.c: Compare affirmative and negativecovenantsand identify examples

of each

CFA®ProgramCurriculum,Volume5,page302

The legalcontractbetween the bondissuer (borrower)and bondholders(lenders) is

calleda trustdeed,andinthe UnitedStatesandCanada, it isalsooften referredto as

the bond indenture.The indenture defines theobligationsof andrestrictions onthe

borrower andforms the basis for allfuturetransactionsbetween thebondholder andthe

issuer

The provisions in thebond indentureareknownas covenantsand includeboth negative

covenants(prohibitionsontheborrower)andaffirmativecovenants (actionstheborrower

promisestoperform)

Negativecovenantsincluderestrictions on assetsales(thecompanycan’tsellassets

that have been pledgedascollateral),negativepledge of collateral(thecompany can’t

claim that thesame assetsback several debtissuessimultaneously), andrestrictions

onadditional borrowings(the companycan’tborrow additionalmoneyunlesscertain

financial conditionsare met).

Negativecovenants serve to protecttheinterestsof bondholdersandpreventtheissuing

firmfromtakingactionsthatwouldincreasethe riskofdefault.At thesame time,the

covenants must notbesorestrictive thattheypreventthefirmfromtaking advantageof

opportunities thatarise orresponding appropriatelytochanging businesscircumstances

Affirmativecovenantsdonottypicallyrestrictthe operating decisions of theissuer.

Commonaffirmativecovenantsaretomake timelyinterestand principalpayments to

bondholders,toinsureandmaintainassets,andtocomply with applicable laws andregulations

LOS51.d:Describe howlegal, regulatory,andtaxconsiderations affect the

issuanceandtradingof fixed-incomesecurities

CFA®ProgramCurriculum, Volume5,page310

Bondsaresubjecttodifferentlegalandregulatoryrequirementsdependingonwhere

theyareissued and traded Bonds issued byafirm domiciledina countryand alsotradedinthatcountry’scurrencyarereferredto asdomestic bonds Bonds issued by

afirm incorporatedinaforeigncountrythat tradeonthe national bond market ofanothercountryinthat country’scurrencyarereferredto asforeign bonds.Examplesinclude bonds issued by foreign firms that tradeinChina andaredenominatedinyuan,

whicharecalled pandabonds-,and bonds issued by firms incorporated outside the UnitedStatesthat tradeinthe United States andaredenominatedinU.S.dollars,whichare

called Yankee bonds

Eurobondsareissued outside the jurisdiction ofany onecountryand denominatedin

acurrencydifferentfrom thecurrencyof thecountries inwhich theyaresold Theyare

subjecttoless regulation than domestic bondsinmostjurisdictions andwereinitiallyintroducedtoavoid U.S.regulations.Eurobonds shouldnotbe confused with bondsdenominatedin euros orthoughttooriginateinEurope,although theycanbe both

Eurobondsgotthe“euro”namebecause theywerefirst introducedinEurope, andmost

arestill traded by firmsinEuropean capitals.Abond issued byaChinese firm thatis

denominatedin yenand tradedinmarkets outside Japan would fit the definition ofa

Eurobond Eurobonds that tradeinthe national bond market ofa countryother thanthecountrythatissuesthecurrencythe bondisdenominatedin,andinthe Eurobond

market, arereferredto asglobal bonds

Eurobondsarereferredtoby thecurrencytheyaredenominatedin.Eurodollar bondsare

denominatedinU.S.dollars,andeuroyenbondsaredenominatedinyen.The majority

of Eurobondsareissuedinbearerform Ownership of bearer bondsisevidenced simply

bypossessing thebonds,whereasownershipofregisteredbondsisrecorded Bearer

bondsmaybemoreattractivethan registered bondstothoseseekingtoavoidtaxes.

Other legal and regulatoryissuesaddressedina trustdeed include:

• Legal information about theentityissuing the bond

• Anyassets(collateral)pledgedto support repaymentof the bond

• Anyadditionalfeaturesthatincreasetheprobabilityofrepayment (credit

enhancements)

• Covenantsdescribingany actionsthe firmmusttakeandany actionsthe firmis

prohibited from taking

Bondsareissued by severaltypesof legalentities,and bondholdersmustbeaware

of whichentityhas actually promisedtomake theinterestand principalpayments.

Sovereign bondsare mostoften issued by thetreasuryof the issuingcountry.

Corporate bondsmaybe issued byawell-known corporation suchasMicrosoft,bya

subsidiary ofacompany,orbyaholdingcompanythatisthe overallownerof several

operating companies Bondholdersmustpay attentiontothespecific entity issuing the

bonds because the credit qualitycandiffer among relatedentities

Sometimesan entity iscreated solely forthe purpose ofowning specificassetsand

issuing bondstoprovide the fundstopurchase theassets.Theseentities arereferredto

variouslyasspecialpurpose entities (SPEs),special purpose vehicles(SPVs), orspecial

purpose companies(SPCs) indifferentcountries.Bonds issued by theseentitiesare

called securitized bonds.Asanexample,afirm could sell loansithas madeto customers

to anSPVthatissuesbondstopurchase the loans Theinterestand principalpayments

ontheloansarethen usedtomake the interest andprincipalpayments onthe bonds

Often,anSPVcanissuebondsat alowerinterestratethan bonds issued by the

originating corporation Thisisbecause theassetssupporting the bondsareowned

by the SPV andareusedtomake thepayments toholdersof the securitized bonds

evenif the company itselfruns intofinancial trouble.Forthisreason,SPVs arecalled

bankruptcyremotevehiclesorentities

SourcesofRepayment

Sovereign bondsaretypicallyrepaid by thetaxreceipts of the issuingcountry.Bonds

issued by nonsovereigngovernmententities arerepaid by either generaltaxes,revenues

ofaspecificproject(e.g.,anairport),orby specialtaxes orfees dedicatedtobond

repayment(e.g.,a waterdistrictor sewer district)

Corporate bondsaregenerallyrepaid from cash generated by the firm’s operations As

noted previously, securitized bondsarerepaid from the cash flows of the financialassets

owned by the SPV

Collateraland Credit Enhancements

Unsecuredbondsrepresent aclaimtothe overallassetsand cash flows of theissuer

Securedbondsarebacked byaclaimtospecificassetsofacorporation,which reduces

their riskof defaultand,consequently, the yield thatinvestors require onthe bonds

Assetspledgedto support abondissue (orany loan) arereferredto ascollateral

Becausetheyarebacked bycollateral,secured bondsare seniortounsecured bonds

Among unsecuredbonds,twodifferentissuesmayhave different priorityintheevent

of bankruptcyorliquidation of the issuingentity.The claimofseniorunsecured debtis

below(after)that of secured debt but ahead of subordinated, orjunior, debt

E Sometimessecured debtisreferredtobythetypeof collateralpledged.Equipmenttrust

certificatesaredebtsecuritiesbacked byequipmentsuchasrailroadcarsand oil drillingrigs Collateraltrustbondsarebacked by financialassets,suchasstocks and(other)bonds.Beawarethat whilethetermdebenturesreferstounsecureddebt in theUnited

Statesandelsewhere,in Great Britainandsomeothercountriesthetermreferstobonds

collateralized by specificassets.

Themost common typeofsecuritized bondis amortgage-backedsecurity(MBS).The

underlyingassets are apoolofmortgages,andtheinterestand principalpaymentsfrom

themortgages areusedtopay the interestand principalontheMBS

Insome countries,especiallyEuropeancountries,financial companiesissuecovered

bonds Covered bondsaresimilartoasset-backedsecurities,buttheunderlyingassets

(thecover pool), although segregated,remainonthe balance sheetofthe issuingcorporation(i.e., noSPV is created).Special legislationprotectstheassetsinthecover

poolin theeventof firm insolvency (theyarebankruptcyremote).Incontrast to an

SPVstructure,coveredbonds alsoproviderecoursetothe issuingfirmthatmustreplace

or augment non-performingassets inthecoverpoolsothatitalways providesfor thepaymentofthecovered bond’s promisedinterestand principalpayments.

Creditenhancement can be eitherinternal(built intothestructureofabondissue)

orexternal (provided byathird party).Onemethodof internalcredit enhancement

is overcollateralization, inwhich the collateral pledged hasavaluegreaterthan thepar

valueofthedebtissued A secondmethodofinternal credit enhancement isexcess

spread,in whichthe yieldonthe financialassetssupportingthe debtisgreaterthan

theyieldpromisedonthebonds issued.This givessomeprotectioniftheyieldonthe

financialassets isless thananticipated Iftheassetsperformasanticipated, theexcess

cash flowfrom the collateralcanbeusedto retire(pay off theprincipalon)someoftheoutstanding bonds

Athird methodofinternal credit enhancementistodivideabondissueintotranches

(Frenchforslices)with differentseniorityof claims.Anylosses duetopoorperformance

of theassetssupportingasecuritizedbondarefirstabsorbedbythebondswiththe

lowestseniority,then the bonds with the next-lowestpriorityof claims Themost senior

tranches in thisstructure canreceiveveryhigh creditratingsbecausetheprobabilityis

verylow thatlosseswillbesolarge that theycannotbeabsorbed bythesubordinated

tranches The subordinated tranchesmusthavehigher yieldsto compensate investorsfor

the additional riskof default Thisis sometimesreferredto aswaterfallstructurebecauseavailable funds firstgotothemostseniortrancheof bonds,thentothe next-highest

prioritybonds,andsoforth

Externalcredit enhancementsincludesuretybonds,bankguarantees,and lettersof

credit from financialinstitutions.Surety bondsareissuedbyinsurancecompanies and

are apromisetomake up any shortfall in the cash availabletoservice thedebt.Bank

guarantees servethesamefunction.Aletterofcreditis apromisetolendmoneytotheissuingentityifitdoesnothave enough cashtomake the promisedpayments onthecovered debt While all three of these external credit enhancementsincreasethe creditquality ofdebt issues and decrease theiryields,deteriorationof the creditqualityof theguarantorwill alsoreducethecredit qualityof the coveredissue.

Taxationof Bond Income

Most often,theinterest incomepaidtobondholdersistaxedasordinaryincome at

thesamerate aswageand salaryincome.The interestincomefrombonds issued by

municipalgovernmentsin theUnitedStates,however, ismostoftenexemptfrom

nationalincometaxandoften fromanystateincometaxinthestateofissue

Whenabondholder sellsacouponbondpriortomaturity,itmay beat againor aloss

relativetoitspurchase price Such gains and lossesareconsidered capital gainsincome

(ratherthanordinary taxableincome).Capital gainsareoften taxedat alowerratethan

ordinaryincome.Capital gainsonthe saleofan assetthathasbeen ownedformorethan

some minimum amountoftimemay be classifiedaslong-term capitalgains and taxedat

an evenlowerrate.

Pure-discount bonds andother bondssoldatsignificant discountstopar whenissued

aretermed originalissuediscount(OID)bonds.Because thegainsoveranOIDbond’s

tenor asthe pricemovestowardsparvaluearereallyinterestincome,these bondscan

generate a taxliabilityevenwhennocashinterest paymenthas been made Inmany

taxjurisdictions,aportion of the discount fromparatissuance istreatedastaxable

interestincomeeach year Thistax treatmentalso allows that thetaxbasisof the OID

bondsisincreasedeach yearbytheamountofinterest incomerecognized,sothereis no

additionalcapital gainstaxliabilityatmaturity

Sometaxjurisdictions provideasymmetrictreatmentforbonds issuedat apremiumto

par,allowingpartofthepremiumtobeusedtoreducethetaxableportion of coupon

interestpayments.

LOS 51.e: Describe how cash flows of fixed-incomesecuritiesarestructured

CFA®ProgramCurriculum,Volume5,page315

Atypicalbond hasabulletstructure.Periodic interestpayments(coupon payments)

aremadeoverthe lifeof thebond,andtheprincipal valueispaidwith the finalinterest

payment atmaturity Theinterestpaymentsarereferredto asthebond’scoupons When

thefinalpaymentincludesalumpsum inadditionto thefinalperiod’sinterest,it is

referredto as aballoonpayment.

Considera$1,000face value 5-year bond withanannualcouponrateof5% With

abulletstructure,the bond’s promisedpayments atthe endof eachyearwould beas

Aloanstructurein whichthe periodicpaymentsinclude bothinterestandsome

repaymentofprincipal(the amount borrowed) iscalledanamortizing loan.Ifa

bond(loan) isfullyamortizing, thismeanstheprincipalisfullypaidoff when the

last periodicpayment ismade Typically, automobile loans andhomeloansarefully

amortizing loans If the 5-year,5% bondinthe previous table hadafully amortizingstructureratherthanabulletstructure,thepaymentsand remaining principal balance

ateach year-end would beasfollows(finalpaymentreflects rounding of previouspayments)

Abondcanalso be structuredtobe partially amortizingsothatthereisaballoon

payment atbond maturity, justaswithabulletstructure However,unlikeabullet

structure,thefinalpaymentincludes just the remaining unamortized principalamountratherthan the full principalamount.Inthe followingtable,thefinalpaymentincludes

$200torepaythe remaining principal outstanding

Sinking fund provisionsprovide for therepaymentof principal throughaseriesof

paymentsoverthe lifeof theissue.Forexample,a20-year issuewithafaceamountof

$300 millionmay requirethat theissuer retire$20 million of theprincipalevery year

beginninginthe sixth year

Detailsof sinking fund provisionsvary.Theremaybeaperiod during whichnosinkingfund redemptionsaremade Theamountof bonds redeemed accordingtothe sinkingfund provision could decline eachyearorincreaseeachyear.Somebond indenturesallow thecompanytoredeemtwicetheamountrequired by the sinking fund provision,whichiscalledadoublingoptionor anaccelerated sinkingfund.

The priceatwhich bondsareredeemed underasinking fund provisionistypically

parbutcanbe different frompar.If the market priceislessthan the sinking fundredemption price, theissuer cansatisfy thesinkingfund provision by buying bondsin

the open market withapar valueequaltotheamountof bonds thatmustbe redeemed

This would be thecaseifinterestrateshadrisen since issuancesothat the bondswere

trading below the sinking fund redemption price

Sinking fund provisions offer both advantages and disadvantagestobondholders On theplusside,bonds withasinking fund provision have less credit risk because the periodicredemptions reduce the totalamountof principaltobe repaidatmaturity Thepresence

ofasinkingfund, however, canbeadisadvantagetobondholders wheninterestratesfall

Thisdisadvantagetobondholderscanbeseenbyconsideringthecasewhereinterestrateshave fallensincebondissuance, sothe bondsaretradingat apriceabove thesinking fund redemption price.Inthiscase,the bondtrusteewill select outstandingbondsfor redemption randomly A bondholder would sufferaloss if her bondswereselectedtobe redeemedat aprice below thecurrentmarket price Thismeansthe bonds

havemorereinvestmentrisk because bondholders who havetheirbonds redeemedcan

onlyreinvestthe fundsatthenew,lower yield (assuming they buy bonds of similarrisk)

topicreviews.Itcanbedefinedastheuncertaintyabout theinterest tobe earned

oncashflowsfromabond thatarereinvestedinother debtsecurities.In thecaseof

abond withasinkingfund,thegreaterprobabilityofreceivingthe principal

repaymentpriortomaturityincreasestheexpectedcashflowsduringthe bond’s

lifeand, therefore,the uncertainty aboutinterest incomeonreinvestedfunds.

Thereareseveral couponstructuresbesidesafixed-couponstructure,andwe summarize

themostimportantoneshere

Floating-RateNotes

Somebonds payperiodicinterestthatdependson a currentmarketrateofinterest

Thesebondsarecalledfloating-ratenotes (FRN) orfloaters The marketrateofinterest

iscalledthereferencerate,andanFRN promisestopay the referencerateplussome

interestmargin.Thisadded marginistypicallyexpressedinbasispoints,whichare

hundredthsof1% A 120basis point marginisequivalentto1.2%

Asanexample,considerafloating-ratenotethat pays the London Interbank Offer Rate

(Libor)plusamargin of0.75% (75basis points) annually If1-yearLiboris 2.3%atthe

beginning ofthe year, thebondwill pay 2.3%+0.75% = 3.05%ofits parvalueatthe

endof the year Thenew1-yearrate atthattimewill determine therateofinterestpaid

atthe endof thenextyear Most floaters payquarterlyandarebasedon aquarterly

(90-day)referencerate.A variable-ratenote is onefor which the margin above the reference

rate is notfixed

Afloating-ratenotemayhaveacap,whichbenefits the issuerby placingalimiton

how high thecouponrate canrise Often, FRNswithcapsalso haveafloor,which

benefits the bondholder by placingaminimumonthecouponrate(regardless of how

lowthereferenceratefalls) An inverse floaterhasacouponratethatincreaseswhen the

referenceratedecreases and decreases when the referencerate increases.

OTHER COUPON STRUCTURES

Step-up couponbondsarestructuredsothat thecouponrateincreasesovertime

accordingto apredetermined schedule Typically,step-upcouponbonds haveacall

Ifthenewhighercouponrate is greaterthan what the marketyield wouldbeatthe call

price, thefirmwill call thebonds andretirethem Thismeansifmarketyieldsrise, a

bondholdermay, inturn, get ahighercouponratebecause the bondsareless likelytobe

calledonthestep-update

Yields couldincreasebecauseanissuer’screditratinghasfallen, inwhichcasethehigher

step-upcouponratesimplycompensatesinvestorsforgreatercredit risk Asidefromthis,

wecan viewstep-upcoupon bondsashavingsomeprotection againstincreases inmarket

interestrates totheextenttheyareoffset byincreases inbond couponrates.

Acredit-linkedcouponbondcarriesaprovisionstating that thecouponratewillgo up

byacertainamountif the creditratingof theissuerfalls andgodown if the creditrating

of theissuerimproves While this offerssomeprotection againstacredit downgrade oftheissuer,the higher requiredcouponpaymentsmaymake the financialsituationof the

issuerworseandpossiblyincreasethe probability of default

Apayment-in-kind(PIK)bond allows theissuertomake thecouponpaymentsbyincreasing the principalamountof theoutstandingbonds,essentially paying bond

interestwith more bonds FirmsthatissuePIKbondstypicallydosobecausetheyanticipate that firm cash flowsmaybe less than requiredtoservicethedebt,oftenbecauseof high levels of debt financing (leverage) These bonds typically have higheryields because ofalower perceived credit quality from cash flow shortfallsorsimplybecause of the high leverage of the issuing firm

Withadeferred couponbond,also calledasplitcouponbond,regularcoupon

paymentsdonotbegin untilaperiod oftimeafterissuance.Theseareissued by firmsthat anticipate cash flows willincrease inthefuturetoallow themtomakecouponinterestpayments.

Deferredcouponbondsmaybe appropriatefinancingforafirm financingalargeproject that willnotbecompletedandgeneratingrevenueforsomeperiodof time after

bondissuance.Deferred coupon bondsmayoffer bondholderstaxadvantagesinsome

jurisdictions.Zero-couponbondscanbe considereda typeof deferred coupon bond

Anindex-linked bond has couponpaymentsand/oraprincipal value thatisbasedona

commodityindex, anequityindex, or someother published index number linked bonds(alsocalledlinkers)arethemost common typeof index-linked bonds

Inflation-Theirpayments arebasedonthe changeinaninflationindex,suchasthe Consumer

PriceIndex(CPI)intheUnited States Indexed bonds that willnotpaylessthan theiroriginal par valueatmaturity, evenwhen the index hasdecreased, aretermed principalprotected bonds

The differentstructuresof inflation-indexed bonds include:

• Indexed-annuity bonds Fully amortizing bonds with the periodicpaymentsdirectly

adjustedfor inflationordeflation

• Indexedzero-couponbonds Thepayment atmaturity isadjusted for inflation

• Interest-indexed bonds The couponrateisadjusted for inflation while theprincipalvalueremainsunchanged

• Capital-indexed bonds Thisisthemost common structure.AnexampleisU.S

TreasuryInflation ProtectedSecurities(TIPS).Thecouponrateremainsconstant,and the principal value of the bondsisincreased by therateof inflation(or

decreased bydeflation).

To better understand thestructureof capital-indexedbonds,considerabond withapar

value of$1,000at issuance, a3%annualcouponratepaid semiannually, andaprovisionthat the principalvalue will be adjusted for inflation(or deflation).Ifsixmonthsafter

issuancethe reported inflation has been1% overthe period, the principal value of the

bondsisincreased by1%from$1,000to$1,010,and the six-month coupon of 1.5%is

calculatedas1.5% of thenew(adjusted)principal value of$1,010 (i.e.,1,010 x1.5%

=$15.15)

Withthisstructure wecan viewthecouponrateof 3%as arealrateofinterest

Unexpected inflation willnotdecrease the purchasingpowerof thecoupon interest

payments,and the principal value paidatmaturity will haveapproximately thesame

purchasingpowerasthe$1,000parvalue didatbondissuance

Equity-linkednotes(ELN)aretraded debtsecurities,typically withnoperiodicinterest

payments,for which thepayment atmaturityisbasedonanequity index Thepayment

may be less than or more than theamount invested,dependingonthechangeinthe

specified indexoverthe lifeof theELN

LOS51.f:Describe contingency provisionsaffectingthe timing and/ornature

of cash flows of fixed-incomesecuritiesand identify whether such provisions

benefit the borrowerorthe lender

CFA®Program Curriculum,Volume5,page 327

Acontingency provisionina contractdescribesan actionthatmaybe taken ifan

event(thecontingency) actuallyoccurs.Contingency provisionsinbond indentures

arereferredto asembeddedoptions,embeddedinthesensethat theyareanintegral

partof the bondcontractandare not a separatesecurity.Someembedded optionsare

exercisableatthe option of theissuerof the bondand, therefore,arevaluabletothe

issuer;othersareexercisableatthe option of the purchaser of the bondand, thus,have

valuetothe bondholder

Bonds that donothave contingency provisionsarereferredto asstraightoroption-free

bonds

Acall option gives theissuerthe righttoredeem allor partofabondissueat aspecific

price(callprice) if they chooseto.Asanexample ofacall provision, considera6%

20-yearbond issuedatpar onJune1, 2012,for which the indenture includes thefollowing

call schedule-

• The bondscanbe redeemed by theissuerat102%ofparafterJune1,2017

• The bondscanbe redeemed by theissuerat101%ofparafterJune1,2020

• The bondscanbe redeemed by theissuerat100%of par afterJune1,2022

For the 5-yearperiod from theissuedate untilJune2017,the bondisnotcallable We

saythe bond has fiveyearsof callprotection,orthat the bondiscallprotected for

five years This 5-yearperiodisalso referredto as alockoutperiod,a cushion, or a

defermentperiod

June1,2017,isreferredto asthefirstcalldate,and the callpriceis 102 (102%of par

value)between that date andJune2020.Theamountby which the call priceisabove par

isreferredto asthe callpremium.The call premiumatthe first call dateinthis example

is2%, or$20per$1,000bond The callpricedeclinesto101(101%of par) after

June1,2020 After,June1,2022,the bondiscallableatpar,and that dateisreferredto

asthefirstparcall date

Forabond thatiscurrentlycallable,the call priceputsanupperlimitonthe valueofthe bondinthe market

Acalloptionhas valuetotheissuerbecauseitgives theissuerthe righttoredeem thebond andissueanewbond(borrow)if the market yieldonthe bond declines Thiscouldoccureither becauseinterestratesingeneral have decreasedorbecause the creditquality of the bond has increased(defaultrisk hasdecreased)

Considerasituationwhere the market yieldonthe previously discussed 6%20-year

bond has declined from 6%atissuanceto4%onJune1,2017(thefirst calldate).Ifthe bond didnothaveacall option,itwould tradeatapproximately$1,224.Withacallprice of102,theissuer canredeem the bondsat$1,020each and borrow thatamount

atthecurrentmarket yield of4%,reducing the annualinterestpaymentfrom $60 perbondto$40.80

Professor’sNote: Thisisanalogoustorefinancingahomemortgagewhenmortgage

ratesfallinordertoreduce themonthlypayments

Theissuerwill only choosetoexercisethe calloptionwhenit istotheiradvantageto

doso.Thatis,theycanreduce theirinterestexpense by callingthe bond and issuing

newbondsat alower yield.Bond buyersaredisadvantaged by the call provision andhavemorereinvestmentrisk because their bonds will only be called(redeemedpriortomaturity) when the proceedscanbe reinvested onlyat alower yield.Forthisreason, a

callable bondmustofferahigheryield(sellat alower price) thananotherwise identicalnoncallable bond The differencein pricebetweenacallable bond andanotherwise

identical noncallable bondisequaltothe valueof the call optiontotheissuer.

Therearethree stylesofexercisefor callable bonds:

1 Americanstyle—the bondscanbe called anytime after the first call date

2 European style—the bondscanonly be calledonthe call date specified

3 Bermuda style—the bondscanbe calledonspecified dates after the first calldate,

oftenoncouponpaymentdates

Notethat theseareonly stylenamesandarenotindicativeof where the bondsare

issued

To avoid the higherinterestratesrequiredoncallable bonds but still preserve the option

toredeem bonds early whencorporate oroperatingeventsrequireit,issuersintroducedbonds with make-whole call provisions Withamake-wholebond,the call priceisnotfixed but includesalump-sumpaymentbasedonthepresentvalueof the futurecoupons

the bondholder willnotreceiveif the bondiscalled early

Withamake-wholecall provision, thecalculatedcall price isunlikelytobelowerthan

the market valueofthe bond Therefore theissuer isunlikelytocall the bondexcept

whencorporate circumstances,suchas anacquisitionorrestructuring, requireit.The

make-whole provision doesnot put anupperlimitonbond values wheninterestrates

fallasdoesaregularcallprovision.The make-wholeprovision actuallypenalizesthe

issuer forcallingthebond.Theneteffectisthat thebondcanbecalled ifnecessary,but

it canalsobeissuedat aloweryieldthanabond withatraditional callprovision

Putable Bonds

Aputoption gives the bondholder therighttosell the bond backtothe issuing company

at aprespecifiedprice,typicallypar.Bondholdersarelikelyto exercisesucha putoption

when thefairvalueofthebondislessthan theputpricebecauseinterestrateshaverisen

orthe credit quality of theissuerhas fallen.Exercisestyles usedaresimilartothosewe

enumeratedfor callable bonds

Unlikeacall option,a putoption has valuetothe bondholder because the choiceof

whethertoexercisethe optionisthe bondholder’s.Forthisreason, aputable bond will

sellat ahigher price(offeraloweryield) comparedto anotherwiseidenticaloption-free

bond

Convertible Bonds

Convertiblebonds,typically issued withmaturitiesof 5-10years,give bondholders the

optiontoexchangethebondforaspecific number ofsharesofthe issuing corporation’s

commonstock This givesbondholdersthe opportunitytoprofitfromincreasesin the

valueof thecommonshares.Regardlessof the price of thecommonshares,the valueof

aconvertible bond will beatleastequaltoitsbond value without theconversion option

Becausetheconversionoptionisvaluableto bondholders,convertible bondscanbe

issued with lower yields comparedtootherwise identical straight bonds

Essentially, theownerofaconvertible bond has the downside protection (comparedto

equityshares)ofabond, butat areduced yield, and the upside opportunity of equity

shares.For thisreasonconvertiblebondsareoftenreferredto as ahybridsecurity,part

debt andpartequity

Toissuers,theadvantagesof issuing convertible bondsare aloweryield(interest cost)

comparedtostraight bonds andthefact thatdebt financingisconvertedtoequity

financing when the bondsareconvertedto commonshares.Sometermsrelatedto

convertible bondsare:

• Conversionprice The price per shareatwhich thebond(at itsparvalue) maybe

convertedto commonstock

• Conversionratio.Equaltotheparvalueofthebond divided bythe conversion

price Ifabond witha $1,000parvalue hasaconversionprice of$40,itsconversion

ratiois 1,000/40 =25 sharesper bond

• Conversionvalue This is the market valueofthe shares thatwouldbe received

upon conversion A bond witha conversion ratioof25shares when thecurrent

market price ofa commonshareis$50 would havea conversionvalueof25x50=

$1,250.

Evenif the share priceincreasesto alevel where theconversionvalueissignificantlyabove the bond’s parvalue,bondholders mightnot convertthe bondstocommonstockuntil theymustbecause theinterestyieldonthe bondsishigher than the dividend yield

onthecommonshares received throughconversion.Forthisreason,manyconvertiblebonds haveacall provision Because the call price will be lessthan theconversionvalue

of theshares,by exercising their call provision, theissuers canforce bondholderstoexercisetheirconversionoption when theconversionvalueissignificantly above the parvalueof the bonds

Warrants

Analternativewaytogive bondholdersanopportunity for additionalreturnswhenthe firm’scommonsharesincrease invalueistoincludewarrantswith straight bondswhen theyareissued.Warrantsgive their holders therighttobuy the firm’scommon

sharesat agiven priceover agivenperiod oftime.Asanexample,warrantsthat givetheir holders the righttobuy shares for $40 willprovide profits if thecommonshares

increase invalue above$40 priortoexpiration ofthewarrants.Forayoung firm,issuingdebtcanbe difficult because the downside (probability of firmfailure) issignificant,and the upsideislimitedtothe promised debtpayments.Includingwarrants,which

aresometimesreferredto as a“sweetener,”makes the debtmoreattractivetoinvestors

becauseitadds potential upside profits if thecommonsharesincrease invalue

Contingent Convertible Bonds

Contingent convertible bonds(referredto as“CoCos”) arebonds thatconvertfrom debt

to commonequity automatically ifaspecificeventoccurs.Thistypeof bond has beenissued bysomeEuropean banks Banksmustmaintainspecific levels of equity financing

Ifabank’s equity falls below the requiredlevel,theymustsomehowraise moreequityfinancingtocomplywithregulations.CoCos areoften structuredsothat if the bank’s

equitycapital falls belowagivenlevel,theyareautomatically convertedtocommon

stock This has theeffect of decreasing the bank’s debt liabilities and increasingitsequitycapitalatthesame time,which helps the bankto meetits minimumequityrequirement

KEY CONCEPTS

LOS 51.a

Basicfeatures ofafixedincomesecurity include theissuer,maturitydate,parvalue,

couponrate,couponfrequency, andcurrency

• Issuersinclude corporations,governments,quasi-governmententities,and

supranationalentities

• Bonds with originalmaturitiesofoneyear orlessaremoneymarketsecurities

Bonds with originalmaturitiesofmorethanone year arecapital marketsecurities

• Par valueistheprincipalamountthat will berepaidtobondholdersatmaturity

Bondsaretradingat apremium if their market priceisgreaterthanparvalueor

tradingat adiscount if their priceisless thanparvalue

• Couponrateisthepercentageofparvalue thatispaid annuallyasinterest.Coupon

frequencymaybeannual, semiannual,quarterly,ormonthly.Zero-couponbonds

paynocouponinterestandarepure discountsecurities

• Bondsmaybe issuedinasinglecurrency,dualcurrencies (one currencyforinterest

and anotherfor principal),orwithabondholder’s choiceofcurrency

LOS51.b

Abond indentureor trustdeedisa contractbetweenabondissuerand thebondholders,

which defines the bond’sfeaturesand the issuer’sobligations.Anindenture specifies the

entityissuing thebond,thesourceof funds forrepayment, assetspledgedascollateral,

creditenhancements,andanycovenantswith which theissuermustcomply

LOS 51.c

Covenantsareprovisions ofabond indenture thatprotectthe bondholders’interests

Negativecovenants arerestrictionson abond issuer’s operatingdecisions,suchas

prohibiting theissuerfrom issuing additional debtorselling theassetspledgedas

collateral Affirmativecovenantsareadministrativeactionstheissuermustperform,such

asmaking theinterestand principalpaymentson time

LOS51.d

Legal and regulatorymattersthat affect fixedincome securitiesinclude the places where

theyareissued andtraded,the issuingentities,sourcesofrepayment,and collateral and

creditenhancements

• Domesticbonds tradeinthe issuer’s homecountryandcurrency.Foreign bonds

arefrom foreignissuersbut denominatedinthecurrencyof thecountrywhere

they trade Eurobondsareissued outside the jurisdiction ofanysinglecountryand

denominatedinacurrencyother than that of thecountries inwhich they trade

• Issuingentities maybea governmentoragency;acorporation, holding company,or

subsidiary;or aspecialpurpose entity

• Thesourceofrepaymentfor sovereign bondsisthe country’s taxing authority.For

non-sovereigngovernmentbonds,thesourcesmaybe taxing authorityorrevenues

fromaproject Corporate bondsarerepaid with funds from the firm’soperations

Securitizedbondsarerepaid with cash flows fromapool of financialassets.

• Bondsaresecured if theyarebacked by specific collateralorunsecured if they

representanoverall claim against the issuer’s cash flows andassets.

• Creditenhancementmaybe internal(overcollateralization,excessspread, trancheswith different priority ofclaims)orexternal (suretybonds,bankguarantees,letters

ofcredit).

Interest income istypically taxedatthesame rate asordinaryincome,while gainsor

lossesfromsellingabondaretaxedatthe capital gainstax rate.However,theincrease

invalue towardparof originalissuediscount bondsisconsideredinterest income In

the UnitedStates, interest incomefrom municipal bondsisusuallytax-exempt atthenational level andinthe issuer’sstate.

LOS 51.e

Abond withabulletstructurepayscouponinterestperiodically andrepaystheentire

principal valueatmaturity

Abond withanamortizingstructurerepayspartofitsprincipalateachpaymentdate.A

fully amortizingstructuremakes equalpaymentsthroughout the bond’s life.Apartiallyamortizingstructurehasaballoonpayment atmaturity, whichrepaysthe remainingprincipalas alumpsum

Asinking fund provision requires theissuertoretireaportion ofabondissueatspecifiedtimesduring the bonds’ life

Floating-ratenoteshave couponratesthat adjust basedonareferenceratesuchasLibor

Othercouponstructuresincludestep-upcouponnotes,credit-linkedcoupon bonds,

payment-in-kindbonds,deferred couponbonds,index-linkedbonds,and equity-linkednotes.

LOS51-f

Embedded options benefit thepartywho has the righttoexercisethem Call optionsbenefit theissuer,whileputoptions andconversionoptions benefit the bondholder

Call options allow theissuertoredeem bondsat aspecified call price

Put options allow the bondholdertosell bonds backtotheissuerat aspecifiedputprice

Conversionoptions allow the bondholdertoexchange bonds foraspecified number ofsharesof the issuer’scommonstock

CONCEPT CHECKERS

Abond’s indenture:

A contains itscovenants.

B isthesame as adebenture

C relates onlytoits interestand principalpayments.

1.

Adual-currencybond pays couponinterestinacurrency:

A of thebondholder’schoice

B other than the home currencyofthe issuer

C other than the currency in which it repaysprincipal

Whichof thefollowing bondcovenants is mostaccurately describedas an

affirmativecovenant? Thebondissuermust not:

A violate lawsorregulations

B sellassetspledgedascollateral

C issue moredebt with thesame orhigherseniority

An investorbuysapure-discountbond,holdsittomaturity,andreceives itsparvalue.Fortaxpurposes,theincrease inthe bond’s valueismostlikelytobe

treatedas:

A acapitalgain

B interest income.

C tax-exemptincome

A 10-yearbondpaysno interestfor three years, then pays$229.25,followed

bypaymentsof $35semiannuallyfor seven years,andanadditional$1,000 at

maturity Thisbondisa:

A step-upbond

B zero-coupon bond

C deferred-coupon bond

Whichof the followingstatementsismost accuratewith regardtofloating-rate

issuesthathavecaps andfloors?

A A capis anadvantagetothebondholder,whileaflooris anadvantagetotheissuer

B A floor is anadvantagetothebondholder, whileacapisanadvantagetotheissuer

C Afloorisanadvantagetoboth theissuerand thebondholder,whileacap is

adisadvantagetoboth the issuer and thebondholder

Whichof the followingmostaccurately describes themaximum pricefora

currently callable bond?

A Its par value

B The call price

C Thepresentvalueof its parvalue

E ANSWERS - CONCEPT CHECKERS

Anindentureis the contractbetweenthe companyanditsbondholders andcontains the bond’s covenants.

1 A

Dual-currencybonds pay coupon interest in one currency andprincipalin a different currency These currencies may or may not include the home currency of the issuer A currency optionbondallowsthebondholder to choose a currency in which to be paid.

Taxauthoritiestypicallytreat the increase in value of apure-discountbond toward par

as interest income to the bondholder In manyjurisdictionsthis interest income is taxed

periodically duringthe life of the bond eventhoughthe bondholder does not receive any cash until maturity.

outcome statements set forth by CFA Institute This topic is also covered in:

StudySession 15

EXAM FOCUS

Thistopicreviewintroducesmanytermsand definitions.Focusondifferenttypes

ofissuers,features of thevariousdebt securitystructures,and why differentsources

of funds have differentinterestcosts.Understandwell the differences between

fixed-rateand floating-rate debt and howratesaredeterminedonfloating-rate debt and for

repurchaseagreements.

LOS52.a:Describe classificationsofglobalfixed-income markets

CFA®Program Curriculum,Volume5,page342

Global bond marketscanbe classified by several bondcharacteristics,includingtype

ofissuer,credit quality,maturity,coupon,currency,geography, indexing, and taxable

status.

Typeofissuer.Commonclassificationsaregovernmentandgovernmentrelatedbonds,

corporatebonds,and structured finance(securitized bonds).Corporate bondsareoften

further classifiedasissuesfrom financial corporations andissuesfrom nonfinancial

corporations Thelargestissuersbytotalvalueof bondsoutstandinginglobalmarkets

arefinancial corporations andgovernments.

Creditquality.Standard&Poor’s(S&P),Moody’s, and Fitch all provide credit ratings

onbonds.ForS&PandFitch,the highest bond ratingsare AAA, AA, A,andBBB,

andareconsideredinvestmentgrade bonds The equivalent ratings by Moody’sareAaa

throughBaa3 Bonds BB+orlower(Bal or lower) aretermedhigh-yield,speculative,

or“junk” bonds Someinstitutionsareprohibited from investinginbondsof less than

investmentgrade

Originalmaturities.Securitieswith originalmaturitiesofoneyear orlessareclassified

asmoneymarketsecurities.Examples include U.S Treasurybills,commercialpaper

(issuedby corporations), and negotiable certificates of deposit,orCDs (issuedbybanks)

Securitieswithoriginalmaturitiesgreaterthanoneyear arereferredto ascapitalmarket

securities

Couponstructure.Bondsareclassifiedaseitherfloating-rateorfixed-ratebonds,

dependingonwhether theircoupon interestpaymentsarestatedinthe bond indenture

ordependonthe levelofashort-term marketreferenceratedeterminedoverthe life

of the bond.Purchasing floating-ratedebt is attractivetosome institutionsthat have

variable-ratesources offunds(liabilities),suchasbanks Thisallowsthese institutionstoavoid the balance sheeteffects ofinterestrateincreasesthat wouldincreasethecostoffunds but leave theinterest incomeat afixedrate.The valueof fixed-rate bonds(assets)

heldwouldfallinthevalue,while thevalueof their liabilities wouldbe much lessaffected

Currencydenomination Abond’s price andreturns aredetermined by theinterestrates

inthebond’s currency.The majorityofbonds issuedaredenominatedin either U.S

whose capital marketsareless well-established than thoseindeveloped markets

Emerging market bondsaretypically viewedasriskierthan developed market bonds and

therefore,havehigher yields

Indexing.Asdiscussedpreviously, the cash flowson somebondsarebasedon anindex

(index-linked bonds).Bondswith cash flowsdetermined byinflationrates arereferred

to asinflation-indexedorinflation-linked bonds Inflation-linked bondsareissuedprimarily bygovernmentsbutalsobysomecorporationsof high credit quality

Taxstatus.Invarious countries, some issuersmayissuebonds thatare exemptfrom

income taxes.Inthe UnitedStates,these bondscan beissued by municipalities andare

called municipalbonds,or munis.Taxexemptbondsaresold with lower yields thantaxable bondsof similar risk andmaturity,toreflect the impact oftaxes ontheafter-taxyieldof taxable bonds

LOS 52.b: Describe theuseof interbank offeredrates as referenceratesin

floating-ratedebt

CFA®ProgramCurriculum, Volume5,page 346

Themostwidely used referencerateforfloating-rate bondsistheLondon Interbank

Offer Rate(Libor),althoughotherreferencerates,suchas Euribor, arealso used Libor

rates arepublished daily for severalcurrenciesandformaturitiesofoneday(overnight

rates) to oneyear.Thus,thereis nosingle“Liborrate” but rathera setofrates,suchas

“30-dayU.S.dollar Libor”or“90-daySwissfranc Libor.”

Therates arebasedonexpectedratesfor unsecured loansfromonebanktoanother

in the interbankmoney market An averageiscalculatedfromasurvey of18banks’

expected borrowingratesinthe interbankmarket,after excludingthehighest and lowest

quotes.

Forfloating-ratebonds,thereferencerate mustmatchthefrequency with which the

couponrate onthebondisreset.Forexample,abond denominatedineuroswitha

couponratethatisresettwiceeachyearmightuse6-montheuroLiboror6-month

Euriboras areferencerate.

LOS52.c:Describe mechanisms availablefor issuing bondsinprimary

markets

CFA®Program Curriculum,Volume5,page353Salesof newly issued bondsarereferredto asprimary markettransactions.Newly issued

bondscanbe registered withsecuritiesregulators for saletothe public,apublic offering,

orsold onlytoqualifiedinvestors, aprivateplacement

Apublic offering of bondsinthe primary marketistypically done with the help ofan

investmentbank Theinvestmentbank has expertiseinthevariousstepsofapublic

offering, including:

• Determiningfunding needs

• Structuring the debtsecurity

• Creating the bond indenture

• Namingabond trustee (a trustcompanyorbanktrustdepartment)

• Registeringtheissuewithsecuritiesregulators

• Assessing demand and pricing the bonds given market conditions

• Selling the bonds

Bondscanbe sold throughanunderwritten offeringor abestefforts offering In

anunderwrittenoffering,theentirebondissue ispurchased from the issuing firm by

theinvestment bank,termed the underwriterinthiscase.Whilesmaller bondissues

may be soldbyasingleinvestment bank,forlargerissues,the lead underwriter heads

asyndicate ofinvestmentbanks who collectively establish the pricing of theissueand

areresponsible for selling the bondstodealers,whointurnsell themtoinvestors.The

syndicate takes the risk that the bonds willnotall be sold

Anewbondissue ispublicized and dealers indicate theirinterest inbuying thebonds,

which provides information aboutappropriate pricing Somebondsaretradedon awhen

issued basisinwhatiscalled thegrey market.Such trading priortotheofferingdate of

the bonds provides additional information about the demand for and market clearing

price (yield) for thenewbondissue

Inabesteffortsoffering, theinvestmentbanks sell the bondsonacommissionbasis

Unlikeanunderwritten offering, theinvestmentbanks donotcommittopurchase the

wholeissue (i.e.,underwrite theissue)

Somebonds,especiallygovernmentbonds, aresold throughan auction

Professor’sNote: Recall thatauctionprocedureswereexplainedindetailintheStudySession coveringmicroeconomics.

U.S.Treasurysecuritiesaresold through single priceauctionswith the majority of

purchases made by primary dealers that participateinpurchases and sales of bonds with

the FederalReserve BankofNew Yorktofacilitate theopenmarketoperationsof the

Fed Individualscanpurchase U.S Treasurysecuritiesthrough theperiodicauctionsas

well,but areasmallpartof the total

Inashelfregistration,abondissue isregistered withsecuritiesregulatorsin itsaggregate

value witha master prospectus.Bondscanthen be issuedover timewhen theissuer

needstoraisefunds.Becauseindividual offerings underashelf registration require lessdisclosure thana separateregistration ofabondissue,only financially sound companies

aregranted this option Insome countries,bondsregistered underashelf registration

canbe sold onlytoqualifiedinvestors

LOS 52.d: Describesecondarymarketsfor bonds

CFA®ProgramCurriculum, Volume5,page358Secondary markets refertothe trading of previously issued bonds Whilesome

governmentbonds andcorporatebondsaretradedonexchanges, thegreatmajority

of bond tradinginthe secondary marketismadeinthedealer,orover-the-counter,

market.Dealerspostbid(purchase) prices and askoroffer (selling) prices forvarious

bondissues.The difference between the bid and askprices isthe dealer’s spread The

averagespreadisoften between10and12basispointsbutvariesacrossindividual bondsaccordingtotheir liquidity andmaybemorethan 50 basis points foranilliquidissue.l

Bond tradesarecleared throughaclearingsystem,justasequities tradesare.Settlement

(theexchange of bonds forcash)typicallyoccursonthe third trading day after the tradedate(T+3)forcorporatebonds,onthenexttrading day after the trade date(T+1)

forgovernmentbonds,andonthe day of the trade(cash settlement)forsomemoneymarket securities

LOS 52.e:Describesecuritiesissuedbysovereigngovernments,non-sovereign

governments, governmentagencies, andsupranationalentities

CFA®ProgramCurriculum, Volume5,page361Sovereign Bonds

Nationalgovernmentsortheirtreasuries issuebonds backed by the taxingpowerof the

governmentthatarereferredto assovereignbonds Bonds issuedinthecurrencyof theissuinggovernmentcarryhigh credit ratings andareconsideredtobe essentially free ofdefault risk Bothasovereign’s abilitytocollecttaxesanditsabilitytoprint thecurrency

supportthesehighcredit ratings

Sovereignnationsalsoissuebonds denominatedin currenciesdifferent from theirown.

Credit ratingsareoftenhigherforasovereign’s localcurrencybonds than for example,

its euro orU.S.dollar-denominated bonds Thisisbecause the nationalgovernment

cannot print thedeveloped marketcurrencyand the developed marketcurrencyvalue

of localcurrencytaxcollectionsisdependentonthe exchangeratebetween thetwo

currencies

1 Fixed Income Markets: Issuance, Trading, and Funding, Choudhry, M.; Mann, S.; and

Whitmer, L.; in CFAProgram 2015LevelICurriculum, Volume5(CFA Institute, 2014).

Tradingismostactiveand pricesmostinformativefor themostrecently issued

governmentsecuritiesofaparticularmaturity.Theseissuesarereferredto ason-the-run

bonds and alsoasbenchmark bonds because the yields of other bondsaredetermined

relativetothe “benchmark” yields of sovereign bonds of similarmaturities

Sovereigngovernmentsissue fixed-rate,floating-rate, and inflation-indexed bonds

NonsovereignGovernmentBonds

Nonsovereigngovernmentbondsareissued bystates,provinces,counties,andsometimes

byentitiescreatedtofund andprovideservicessuchasfor theconstructionofhospitals,

airports, and othermunicipalservices.Paymentsonthe bondsmaybe supported by the

revenuesofaspecificproject,from generaltax revenues, orfrom specialtaxes orfees

dedicatedtotherepaymentof project debt

Nonsovereign bondsaretypically of high credit quality, but sovereign bonds typically

trade withloweryields (higher prices) because their credit riskisperceivedtobe less

than that of nonsovereign bonds

Professor’sNote: Wewillexaminethe creditqualityofsovereignandnonsovereigngovernmentbondsinourtopicreviewof“FundamentalsofCredit Analysis.”

Agency Bonds

Agencyorquasi-government bondsareissued byentitiescreated by national

governmentsfor specific purposes suchasfinancing small businessesorproviding

mortgagefinancing In the UnitedStates,bondsareissued by government-sponsored

enterprises(GSEs),suchasthe Federal National MortgageAssociationand the Tennessee

Valley Authority

Somequasi-government bondsarebacked by the nationalgovernment,which gives them

highcredit quality Even thosenotbacked by the nationalgovernmenttypically have

high credit quality although their yieldsaremarginally higher than those of sovereign

bonds

SupranationalBonds

Supranational bondsareissuedbysupranational agencies, also knownasmultilateral

agencies.Examplesarethe WorldBank,theIMF,and theAsianDevelopment Bank

Bonds issued by supranational agencies typically have high credit quality andcanbevery

liquid, especially largeissuesof well-knownentities

LOS52.f: Describetypesof debt issued by corporations.

CFA®ProgramCurriculum, Volume5,page367Bank Debt

Mostcorporations fund their businessesto some extentwith bank loans Theseare

typicallyLibor-based,variable-rate loans When the loan involves onlyonebank, it is

referredto as abilateralloan.Incontrast,whenaloanisfunded by severalbanks, it

isreferredto as asyndicated loan and the group of banksisthe syndicate Thereisa

secondarymarket insyndicatedloanintereststhat are alsosecuritized,creating bonds

thataresoldtoinvestors

Commercial PaperForlarger creditworthycorporations,fundingcosts canbe reducedbyissuing short¬

termdebtsecuritiesreferredto ascommercial paper.Forthesefirms,theinterestcost

of commercialpaper islessthan theintereston abank loan Commercialpaperyields

morethan short-term sovereign debt becauseit has,onaverage,morecredit risk and lessliquidity

Firmsusecommercialpapertofund working capital andas a temporarysourceof fundspriortoissuinglonger-termdebt Debt thatistemporaryuntilpermanentfinancingcan

be securedisreferredto asbridge financing

Commercialpaper isashort-term,unsecured debtinstrument.Inthe UnitedStates,

commercial paperisissued withmaturitiesof 270 daysor less,because debtsecurities

withmaturitiesof 270 daysorlessareexemptfrom SEC registration Eurocommercial

paper(ECP) isissued in severalcountrieswithmaturities aslongas364days

Commercialpaper isissued withmaturitiesasshortas oneday (overnight paper), with

mostissuesmaturinginabout 90 days

Commercialpaper isoften reissuedorrolledoverwhenitmatures.The riskthata

companywillnotbe abletosellnewcommercialpapertoreplace maturingpaper istermed rollover risk Thetwoimportant circumstancesinwhichacompany will face

rollover difficultiesare (1)thereisadeteriorationinacompany’sactualorperceivedabilitytorepay the debtatmaturity,which will significantlyincreasethe required yield

onthepaperorleadtoless-than-full subscriptionto a new issue,and (2)significantsystemic financialdistress,as wasexperiencedinthe2008financialcrisis,thatmay

“freeze” debt marketssothatverylittle commercialpaper canbe soldatall

Inorderto get anacceptable credit rating from the ratingsservicesontheir commercial

paper,corporationsmaintainbackuplinesof credit with banks Thesearesometimes

referredto asliquidity enhancementorbackup liquidity lines The bank agreestoprovidethe funds when the papermatures,ifneeded,exceptinthecaseofamaterial adversechange(i.e.,when thecompany’sfinancialsituationhas deteriorated significantly)

SimilartoU.S.T-bills,commercial paperinthe United Statesistypically issuedas a

purediscountsecurity,makingasinglepaymentequaltotheface valueatmaturity

Pricesarequotedas a percentagediscountfrom face value.Incontrast,ECPratesare

quotedasanadd-on yield, thatis,thepercentageinterestpaidatmaturity inadditionto

the par value of the commercial paper

Professor’sNote:RecallfromQuantitativeMethods thata180-day T-billquoted

atadiscountyieldof2%forthe 180-day periodispricedat$980per$1,000face

value Theeffective180-dayreturn is 1,000/980-1=2.041%.ForECPwith

a180-day,add-onyieldof2%,theeffectivereturn issimply2%

Corporate Bonds

Inthe previous topicreview, wediscussed severalfeatures ofcorporatebonds Corporate

bondsareissued withvariouscouponstructuresand with both fixed-rate and

floating-ratecouponpayments.Theymaybe secured by collateralorunsecured andmayhave

call,put,orconversion provisions

Wealso discussedasinking fund provisionas awaytoreduce the credit risk ofabond

by redeemingpartof the bondissueperiodicallyover abond’s life.Analternativeto a

sinkingfund provisionistoissueaserialbondissue.Withaserial bondissue,bondsare

issued with severalmaturitydatessothataportionof theissue isredeemed periodically

Animportant difference betweenaserial bondissueandan issuewithasinking fund

isthat withaserial bondissue, investorsknowat issuancewhenspecificbonds will be

redeemed.Abondissuethat doesnothaveaserialmaturitystructureissaidtohavea

termmaturitystructurewith all the bonds maturingonthesamedate

Ingeneral,corporatebondsarereferredto asshort-term if theyareissued with

maturitiesofupto5years,medium-term when issued withmaturitiesfrom5to12

years, andlong-termwhen maturities exceed12years

Corporationsissuedebtsecuritiescalled medium-termnotes (MTNs),whicharenot

necessarily medium-termin maturity.MTNsareissuedin variousmaturities,ranging

from ninemonthstoperiodsaslongas100years Issuersprovide maturity ranges (e.g.,

18monthsto twoyears) for MTNs they wishtosell and provide yieldquotesfor

those ranges Investors interestedinpurchasingthenotesmakeanoffertothe issuer’s

agent,specifying the face value andan exactmaturity withinoneof therangesoffered

Theagentthen confirms the issuer’swillingnesstosell thoseMTNsandeffects the

transaction

MTNscanhave fixed-orfloating-ratecoupons,but longer-maturityMTNsaretypically

fixed-rate bonds.MostMTNs,other than long-termMTNs, areissued by financial

corporations andmostbuyersarefinancialinstitutions.MTNscanbe structuredto meet

an institution’sspecifications Whilecustombondissueshave less liquidity, they provide

slightly higher yieldscomparedto anissuer’spublicly traded bonds

E LOS52.g:Describe short-termfundingalternatives availabletobanks.

CFA®ProgramCurriculum, Volume5,page 375

Customerdeposits(retaildeposits)are ashort-termfundingsourcefor banks.Checkingaccountsprovidetransactions servicesand immediate availabilityoffunds but typically

payno interest. Money market mutual funds and savingsaccountsprovide less liquidity

orlesstransactionsservices, orboth,andpayperiodicinterest

Inadditiontofundsfrom retailaccounts,banksofferinterest-bearing certificatesof

deposit(CDs)thatmature onspecific dates andareofferedinarangeof short-term

maturities.NonnegotiableCDscannotbe sold and withdrawalof funds oftenincursa

significant penalty

Negotiable certificates of depositcanbesold.At thewholesalelevel,large denomination(typicallymorethan$1million)negotiableCDsare animportantfundingsourceforbanks.They typicallyhave maturities ofoneyearorlessandaretradedindomestic bond

marketsaswellas inthe Eurobond market

Another source of short-termfundingfor banksis toborrowexcess reservesfrom otherbanks in the central bankfundsmarket Banks inmostcountriesmust maintain a

portion oftheir fundsasreservesondeposit withthe centralbank.At any point intime, somebanksmayhavemorethan the requiredamountofreserves ondeposit, while

others requiremore reservedeposits.In the market for central bankfunds,banks withexcess reserveslend themtoother banksforperiodsofoneday (overnightfunds)and

forlongerperiodsupto ayear(term funds).Centralbankfundsratesreferto ratesfor

thesetransactions,whicharestrongly influenced by theeffect ofthe centralbank’s open

marketoperationsonthe moneysupply and availabilityofshort-term funds

In the UnitedStates,the central bank fundsrate iscalled the Fed fundsrateand thisrateinfluences theinterestratesofmanyshort-term debtsecurities

Other than reservesondeposit withthecentralbank,funds thatareloaned byone

banktoanotherarereferredto asinterbank funds Interbank fundsareloaned betweenbanksfor periods ofonedayto ayear.These loansareunsecuredand,aswithmanydebt

markets,liquiditymay decreaseseverely duringtimesofsystemic financial distress

LOS52.h: Describerepurchaseagreements(repos) and their importanceto

investorswho borrow shortterm.

CFA®ProgramCurriculum, Volume5,page 377

Arepurchase (repo)agreementisan arrangementby whichone partysellsasecurityto

a counterpartywithacommitmenttobuyitbackat alater dateat aspecified (higher)price Therepurchaseprice isgreaterthan the selling price andaccountsfor theinterest

charged bythe buyer,whois,in effect,lendingfundstothe seller with the securityascollateral Theinterest rateimplied bythetwopricesiscalledthereporate,whichisthe

annualizedpercentagedifference betweenthetwoprices Arepurchaseagreementforonedayiscalledanovernightrepoandan agreementcoveringalonger periodiscalleda

termrepo.Theinterestcostofarepoiscustomarily less than therateonbank loansor

other short-term borrowing

Asanexample, considerafirm thatentersintoarepoagreement tosella4%, 12-year

bond withaparvalueof $1 million andamarket valueof$970,000for$940,000and

torepurchaseit90 days later(the repo date)for$947,050

The implicitinterestratefor the 90-day loan periodis 947,050/ 940,000 -1=0.75%

and thereporatewould be expressedasthe equivalent annualrate.

Thepercentagedifference between the market value and theamountloanediscalled the

repo marginorthe haircut.In ourexample,it is 940,000 /970,000-1=-3.1% This

marginprotectsthe lenderintheeventthat the value of thesecuritydecreasesoverthe

termof therepoagreement.

Thereporateis:

• Higher, the longer therepoterm.

• Lower,the higher the credit quality of the collateralsecurity

• Lowerwhen the collateralsecurity isdeliveredtothe lender

• Higher when theinterestratesfor alternativesourcesof fundsarehigher

The repo marginisinfluenced by similar factors The repo marginis:

• Higher, the longer therepoterm.

• Lower,the higher the credit quality of the collateral security

• Lower,the higher the credit quality of the borrower

• Lowerwhen the collateralsecurity is inhigh demandorlow supply

Thereasonthe supply and demand conditions for the collateral security affects pricingis

thatsomelenderswant to own aspecific bondor typeof bondascollateral.Forabond

thatishighdemand,lendersmust competefor bonds by offering lowerrepolending

rates.

Viewedfrom the standpoint ofabonddealer,areverserepoagreementreferstotaking

the opposite side ofarepurchasetransaction,lending funds by buying the collateral

securityratherthan selling the collateralsecuritytoborrow funds

KEY CONCEPTS

LOS 52.a

Globalbond marketscanbe classifiedby:

• Typeofissuer:Government (andgovernment-related),corporate(financialand

nonfinancial),securitized

• Credit quality: Investment grade,noninvestmentgrade

• Originalmaturity:Money market(one year or less),capital market(morethanone

year)

• Coupon: Fixedrate,floatingrate.

• Currencyand geography:Domestic,foreign, global, eurobondmarkets;developed,emerging markets

• Otherclassifications: Indexing, taxablestatus.

LOS52.bInterbank lendingrates,suchasLondon Interbank Offered Rate(Libor), arefrequentlyusedasreferenceratesforfloating-ratedebt.Anappropriate referencerateis onethatmatchesafloating-rate note’scurrencyandfrequency ofrate resets,suchas6-monthU.S.dollar Liborforasemiannual floating-ratenoteissuedinU.S.dollars

LOS 52.cBondsmaybe issuedinthe primary market throughapublic offeringoraprivateplacement

Apublicofferingusingan investmentbankmaybeunderwritten,withtheinvestment

bankorsyndicate purchasing theentire issueand selling the bondstodealers;

best-effortsbasis, inwhich theinvestmentbank sells the bondson commission.Publicofferingsmayalso take place throughauctions,whichisthe method commonly usedto

issuegovernmentdebt

or ona

Aprivateplacementisthe saleofan entire issueto aqualifiedinvestororgroup of

investors,whicharetypically largeinstitutions

LOS 52.d

Bonds that have been issuedpreviouslytradeinsecondarymarkets Whilesomebonds

tradeonexchanges,most aretradedindealer markets Spreads between bid and askpricesare narrowerfor liquidissuesand wider for less liquidissues

Trade settlementistypically three days afteratradeforcorporatebonds, oneday aftera

tradeforgovernmentbonds,and same-day settlement formoneymarketinstruments

LOS 52.e

Sovereign bondsareissued by nationalgovernmentsand backed by their taxing power

Sovereign bondsmaybe denominatedinthe localcurrency oraforeigncurrency

Nonsovereigngovernmentbondsareissued bygovernmentsbelow the nationallevel,

suchasprovincesor cities,andmaybe backed by taxing authorityor revenuesfroma

specific project

Agencyorquasi-government bondsareissued bygovernmentsponsoredentitiesandmay

be explicitlyorimplicitly backed by thegovernment.

Supranational bondsareissued by multilateral agencies thatoperateacrossnational

borders

LOS52.f

Debt issued by corporations includes bankdebt,commercialpaper,corporatebonds,

and medium-termnotes.

Bank debt includes bilateral loans fromasingle bank and syndicated loans frommultiple

banks

Commercial paperisamoneymarketinstrumentissued by corporations of high credit

quality

Corporate bondsmayhavea termmaturitystructure(allbondsinan issuemature atthe

same time)oraserialmaturitystructure(bonds in an issuematureonapredetermined

schedule)andmayhaveasinking fund provision

Medium-termnotesarecorporateissuesthatcanbe structuredto meetthe requirements

ofinvestors.

LOS 52.g

Short-term funding alternatives availabletobanks include:

• Customerdeposits, including checkingaccounts,savingsaccounts,andmoney

market mutual funds

• NegotiableCDs,whichmaybesoldin the wholesale market

• Centralbank fundsmarket.Banksmaybuyorsellexcessreservesdeposited with

their central bank

• Interbank funds Banks make unsecured loanstooneanotherfor periods upto a

year

LOS52.h

Arepurchaseagreementisaform of short-term collateralized borrowinginwhichone

partysellsasecuritytoanotherpartyand agreestobuyitbackat apredetermined future

date and price Thereporateisthe implicitinterestrateofarepurchaseagreement.The

repomargin,orhaircut, isthe difference between theamountborrowed and the value of

thesecurity

Repurchaseagreements are animportantsourceof short-termfinancingfor bond

dealers Ifabond dealerislending funds instead of borrowing, theagreementisknown

E CONCEPT CHECKERS

Ananalystwhodescribesafixed-incomesecurityasbeingastructuredfinance

instrument isclassifyingthe securityby:

A credit quality

B typeofissuer

C taxablestatus.

1.

Liborrates aredetermined:

A bycountries’central banks

B bymoneymarket regulators

C intheinterbanklendingmarket

Inwhichtypeof primary markettransactiondoesaninvestment bank sellbonds

Sovereign bondsaredescribedason-the-run when they:

A arethemost recentissue inaspecificmaturity

B have increased substantiallyinpricesincetheywereissued

C receivegreater-than-expected demand fromauctionbidders

Aninvestorwhobuys€100,000face value ofnewlyissued eurocommercialpaperand holdsit tomaturityis mostlikelytopay:

A less than€100,000andreceive€100,000 atmaturity

B €100,000andreceivemorethan€100,000 atmaturity

C less than€100,000andreceive morethan€100,000 atmaturity

Smith Bank lendsJohnsonBankexcess reserves ondeposit with the central bank

foraperiodof three months Is thistransactionsaidto occur inthe interbankmarket?

A Yes

8.

B No,becausethe interbank marketreferstoloansformorethanoneyear

C No,becausethe interbankmarket doesnotincludereservesatthe central

bank

Inarepurchaseagreement,thepercentagedifference betweentherepurchase

priceandtheamountborrowedismostaccurately describedasthe:

A haircut

B reporate.

C repo margin

9

ANSWERS - CONCEPT CHECKERS

In a best-effortsoffering,an investment bank or banksdonotunderwrite(i.e.,purchase

all of) a bond issue, but rather sell the bonds on a commission basis Bonds soldbyauction are offered directly to buyers by the issuer,typicallya government.

3 B

4 A The secondary market for bonds isprimarilya dealer market in which dealers post bid and ask prices.

Sovereignbondsaredescribedason-the-runorbenchmarkwhentheyrepresent the most

recent issue in aspecificmaturity.

With asinkingfund, the issuer must redeem part of the issue prior to maturity, but the

specificbonds to be redeemed are not known Serial bonds are issued with a schedule of maturitiesand eachbond has a known maturitydate.In an issue with a term maturity structure, all the bonds are scheduled to mature on the same date.

7 B

The interbank market refers to short-termborrowingandlendingamong banks of funds other than those ondepositat a central bank Loans of reserves ondepositwith a central bank aresaidto occur in the central bankfundsmarket.

8 C

The repo rate is the percentagedifference betweenthe repurchase price and the amount borrowed The repo margin or haircut is the percentage difference between the amount borrowed and the value of the collateral.

9 B